The Top 6 Tax Planning Mistakes High-Net-Worth Investors Make (And How to Avoid Them)

For high-net-worth investors, effective tax planning isn’t just about reducing liabilities—it’s about protecting and growing wealth over the long term. With complex and ever-evolving tax laws, it’s easy to miss opportunities or make decisions that lead to unnecessary costs.

By making smarter tax choices, you can optimize your returns, minimize your tax burden, and retain more of what you’ve built. Let’s take a look at six common tax planning mistakes and the strategies that can help you avoid them.

1. Neglecting Tax Diversification

The Mistake:
Many high-net-worth investors focus primarily on tax-deferred accounts, such as traditional IRAs or 401(k)s, without giving enough consideration to tax-free options like Roth IRAs or tax-advantaged accounts like Health Savings Accounts (HSAs). Without a well-rounded approach, you might find yourself paying more in taxes during retirement than necessary.

The Fix:
Just as diversification is key to your investment strategy, it's also important to diversify the types of accounts you hold. There are three main account types to consider: Tax-deferred, tax-free, and taxable.

While contributing to tax-deferred accounts, such as traditional IRAs or 401(k)s, is often a priority for high-net-worth investors to reduce taxable income in the short term, spreading your wealth across all three types of accounts can offer more flexibility both now and in retirement. For example, incorporating tax-free options like Roth IRAs into your strategy can help protect you from future tax increases and offer other significant benefits, such as reducing Medicare’s IRMAA (Income-Related Monthly Adjustment Amount) surcharge.

On the other hand, taxable brokerage accounts provide two key advantages: Investments are taxed at capital gains rates (which are typically lower than ordinary income tax rates), and there are no penalties for withdrawals. This makes taxable accounts particularly well-suited for a variety of goals—such as funding an early retirement.

Strategically managing withdrawals from these various account types allows you to balance your tax liabilities and optimize income streams, making tax diversification a critical element of long-term financial planning.

Ultimately, taxes on your investments are unavoidable—it’s just a matter of deciding when and how you pay them.

2. Ignoring Capital Gains Taxes

The Mistake:
Capital gains taxes can take a sizable chunk out of your investment returns. However, many investors don’t fully consider using capital gains rules to their advantage, nor do they understand the distinction between short-term and long-term capital gains taxes.

The Fix:
First and foremost, it's key to understand that short-term gains, which apply to assets held for less than a year, are taxed at ordinary income rates—which have historically been higher than the tax rates applied to long-term gains for assets held for more than a year.

This is why one of the most effective strategies for minimizing capital gains taxes is to focus on holding investments for the long term. This approach is particularly beneficial if you're in a high tax bracket, allowing you to keep more of your returns.

In addition to this strategy, tax-loss harvesting—selling investments that have declined in value to offset gains—can help reduce your tax burden. For example, if you sell an investment at a gain of $100,000, but also sell another at a loss of $50,000, you can offset the gain by the loss, reducing your taxable capital gains by $50,000. (Note: If your total capital losses exceed your capital gains in a given year, you can only use up to $3,000 of the excess losses to offset other types of income, such as wages or interest income. Any remaining losses can be carried forward to future tax years, where they can continue to offset future capital gains or up to $3,000 of ordinary income each year until they are fully utilized.)

Another effective strategy is to plan the selling of appreciated assets around years when your taxable income is lower, such as during retirement or in years with substantial deductions or losses. This can help you reduce your overall tax liability in those years.

As for the next generation, consider gifting appreciated assets to heirs. This can be especially advantageous if the beneficiary is in a lower tax bracket, as they may be subject to a reduced capital gains rate when they eventually sell the assets. Furthermore, assets passed on through an estate generally receive a "step-up in basis," meaning the capital gains tax is calculated from the value of the asset at the time of inheritance, not when it was originally purchased. This means, for example, if you purchased a stock for $100,000, but it appreciated to $300,000 at the time of your death, your heirs would inherit the stock at the $300,000 value, rather than $100,000. They would only be taxed on the appreciation from that $300,000 value when they sell it, potentially saving them significant tax dollars.

3. Overlooking Roth IRA Conversions

The Mistake:
Roth IRAs offer tax-free growth and tax-free withdrawals in retirement. But many investors overlook the opportunity to convert traditional IRA assets into Roth IRAs, particularly during low-income years, to lock in taxes at a more favorable rate.

The Fix:
A Roth IRA conversion during years when your income is lower than usual can be a powerful wealth building tool. If you expect your income to increase in the future, converting funds to a Roth IRA when your current tax rate is lower could help you avoid paying higher taxes down the road. While there will be taxes due on the amount converted, the long-term benefits of tax-free growth and withdrawals could outweigh the immediate tax hit.

However, it's important to carefully assess how much to convert each year to avoid pushing yourself into a higher tax bracket. Working with a trusted fiduciary financial advisor to determine the right amount of conversion is a smart way to optimize this strategy.

4. Underestimating the Impact of Required Minimum Distributions (RMDs)

The Mistake:
Once you turn 73 (as of 2023), the IRS requires you to start taking Required Minimum Distributions (RMDs) from tax-deferred retirement accounts, such as IRAs and 401(k)s. RMDs are taxed as ordinary income, and many investors don’t fully account for how these distributions might push them into a higher tax bracket.

The Fix:
For high-net-worth investors, it’s especially advantageous to start planning for RMDs well in advance. Drawing down tax-deferred retirement accounts earlier than required can help reduce the amount you’ll need to take later on, thus potentially lowering your RMDs and the taxes that come with them. By spreading out distributions over time, you might also avoid being pushed into a higher tax bracket in retirement.

Another strategy to consider is the aforementioned Roth conversion. By converting a portion of your traditional IRA or 401(k) into a Roth IRA before you reach the RMD age, you can pay taxes at today’s rates and reduce the future RMD burden. While you’ll need to pay taxes on the conversion amount upfront, the benefit is that Roth IRAs are not subject to RMDs, and the growth is tax-free.

Charitable giving can be particularly valuable as well (as we'll address below), as direct donations from an IRA to charity can count toward your RMD, while reducing taxable income for the year. For high-net-worth investors who are charitably inclined, this can be a win-win.

5. Not Taking Full Advantage of Tax-Deferred Growth

The Mistake:
Many high-net-worth investors are already maxing out contributions to tax-deferred accounts like 401(k)s and IRAs. However, even for those who are diligent in this regard, there are often additional opportunities for maximizing tax-deferred growth that remain overlooked.

The Fix:
Beyond simply contributing the maximum allowed to traditional tax-deferred accounts, you might consider more advanced strategies to further boost your retirement savings in a tax-efficient way. For example, high-income earners can benefit from after-tax contributions to 401(k)s, which, when structured properly, can be converted into a Roth account through the "Mega Backdoor Roth" strategy. This allows for significantly higher annual contributions to Roth accounts than the standard limits.

Additionally, if you're investing in alternative assets like real estate or private equity through a tax-deferred account, those investments can benefit from tax-deferred growth just like traditional assets—offering even more growth potential. While these strategies require careful planning and a clear understanding of the tax implications, they can significantly enhance your overall wealth accumulation strategy.

6. Lack of Strategic Charitable Giving

The Mistake:
Charitable giving offers a great opportunity to reduce your taxable income, yet many high-net-worth investors fail to integrate it into their overall tax planning strategy. Not only can charitable donations support causes you care about, but they can also provide significant tax benefits.

The Fix:

Donating appreciated assets—such as stocks, bonds, or real estate—can help you avoid paying capital gains taxes, while allowing you to receive a charitable deduction based on the fair market value of the asset.

Another strategy is using Donor-Advised Funds (DAFs), which provide a tax-efficient way to make charitable contributions while retaining flexibility over when and how donations are made. When you contribute to a DAF, you receive an immediate charitable tax deduction for the full amount of the contribution in the year it’s made, even if the funds are not distributed to charities until later. This is particularly useful for investors looking to reduce their taxable income in high-income years.

For those who are 70 ½ and older, qualified charitable donations (QCDs) directly from your IRA to a qualified charity can also reduce taxable income for the year (and, as previously mentioned, can fulfill RMD requirements when applicable).

Final Thoughts

A thoughtful, well-structured tax planning strategy is essential for maximizing the potential of your investments while minimizing the impact of taxes. Keep in mind that tax planning is a dynamic, ongoing process, and working with a fiduciary financial advisor can help ensure your approach remains effective as your personal situation—and tax laws—evolve.

Curious about how we can help integrate a customized tax planning strategy into your financial plan? Reach out to learn more.